Economic and Monetary Union:  aka European Monetary Union Primer on EMU

Andrew Rose, Global Macroeconomics  EMU

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Dates • Formal Start: Jan 1999 F l St t J 1999 • Currency Physically Introduced: Jan 2002 Currency Physically Introduced: Jan 2002 – Countries Have Acceded since 2001

Andrew Rose, Global Macroeconomics  EMU

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Members • Original Original (11) members: Austria, Belgium, Finland,  (11) members: Austria Belgium Finland France, Germany, Ireland, Italy, Luxembourg,  Netherlands, Portugal, Spain , g , p • Later entrants: Greece (2001); Slovenia (2007);  Cyprus (2008); Malta (2008); Slovakia (2009); Cyprus (2008); Malta (2008); Slovakia (2009);  Estonia (2011); Latvia (2014); Lithuania (2015) • Accession countries must Accession countries must try for entry via ERM try for entry via ERM‐2 2 – Denmark and UK have formal “opt‐outs”

Andrew Rose, Global Macroeconomics  EMU

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European Central Bank (ECB) European Central Bank (ECB) • Frankfurt (close to Buba) ( ) • Run by executive board of six  (non‐renewable  terms of eight years) • Supervised by Governing Council (Executive  ( Board plus national central bank governors = “E  System of CBs” or ESCB), ruling by simple  System of CBs or ESCB), ruling by simple majority • Highly independent • Objective of Price Stability (interpreted as  inflation close to but less than 2%); subordinate  general economic policies economic policies” “general Andrew Rose, Global Macroeconomics  EMU

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EMU Benefits EMU Benefits • Convergence Convergence of all European inflation rates to  of all European inflation rates to German rates • Impossibility of  Impossibility of “Beggar Beggar Thy Neighbor Thy Neighbor”  competitive devaluations – UK, Italy, and Sweden in 1992 , y,

• Reduction in exchange rate volatility (thus  transactions costs)) – How important for business?  Easy to hedge most  risk via derivatives Andrew Rose, Global Macroeconomics  EMU

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Costs of EMU Costs of EMU • Loss of exchange rate as macroeconomic tool  L f h t i t l – Only relevant if shocks differ by member state and Only relevant if shocks differ by member state and – Nominal devaluations have real effects – Recall Mundell’s “Optimum Currency Area”  criteria

Andrew Rose, Global Macroeconomics  EMU

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“Convergence Convergence Criteria Criteria” 1 1 • Required for entry into EMU R i df t i t EMU • To be applied by the Council of Ministers To be applied by the Council of Ministers • Mostly Economic, but Highly Politicized y g y

Andrew Rose, Global Macroeconomics  EMU

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Convergence Criteria, 2 Convergence Criteria, 2 1.. Institutions  st tut o s – Central bank independence

2. Inflation – CPI inflation within 1.5% of target; – Target is average inflation of three EU countries with  l lowest inflation  fl

3. Interest Rates –A Average long‐term interest rates within 2% of target; l t i t t t ithi 2% f t t – Target is average long‐term interest rate of the three  low‐inflation countries Andrew Rose, Global Macroeconomics  EMU

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Convergence Criteria, 3 Convergence Criteria, 3 4.. Exchange Rates c a ge ates – Exchange Rates within “normal (?) bounds” ERM of  EMS, 15% (!) – No realignment within last two years

5. Fiscal Positions:  “Sustainable Government  Fi Financial Position”, defined as: i l P iti ” d fi d a) Flow: Deficit/GDP ratio of less than 3%, and b) Stock: Debt/GDP ratio of less than 60% Stock: Debt/GDP ratio of less than 60% – “Escape clauses” exist for “temporary circumstances”  or declining debt Andrew Rose, Global Macroeconomics  EMU

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Stability (and Growth) Pact Stability (and Growth) Pact • “Ins” Ins  should maintain deficits of less than 3%  should maintain deficits of less than 3% GDP or face penalties  – German origins g – Implies pro‐cyclic fiscal policy

• Widely flouted by large countries in practice y y g p – France ‘03‐’07, Germany ‘03‐’06, Italy ‘03‐? – Also breaches by Greece, Netherlands, Portugal y g – Reformed slightly in 2005 – Revived at summit in December 2011 Andrew Rose, Global Macroeconomics  EMU

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EMU and Fiscal Policy EMU and Fiscal Policy •

Article 103 Maastricht Treaty “No Bail‐Out” – ““… neither the Community nor any Member State is liable for or can assume the  neither the Comm nit nor an Member State is liable for or can ass me the commitments of any other Member State”

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European Financial Stabilization Mechanism (EFSM) – EC funds (from EU budget) of €60 bn

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European Financial Stability Facility (EFSF) European Financial Stability Facility (EFSF) – May 2010: to “safeguard financial stability in Europe” – Can issue €440 bn of bonds, guaranteed by members, to lend to members “in difficulty” who  request help, s.t. EC, ECB, IMF (“troika”) conditionality – Greece requested and received rescue package from EU/IMF (€110 bn), May 2010 – Ireland and Portugal followed

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European Stability Mechanism (ESM) – Permanent bailout kitty aka “Firewall” – Increased in late March 2012 to €500bn, started 7/2012, fully ready by 2014 (!) – Probably still too small (German objections;  France + others wanted €1 tn) – EFSF + ESM limit is €700 bn – Draghi, Sept 2012: ESM approval implies unlimited ECB support

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European Monetary Fund (EMF) started July 2012 European Banking Union (stress tests Fall 2014) European Banking Union (stress tests, Fall 2014) Andrew Rose, Global Macroeconomics  EMU

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Optimum Currency Areas Optimum Currency Areas • Economists usually ask two questions on EMU E it ll kt ti EMU – “Do Do European Countries look like an Optimum  European Countries look like an Optimum Currency Area?” and – “Are European Countries similar to American  Regions? Regions?”

Andrew Rose, Global Macroeconomics  EMU

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Issues of Relevance Issues of Relevance • Assessing OCA criteria for EMU Assessing OCA criteria for EMU – What are the benefits arising from increased international  trade between areas? – How synchronized are the business cycles across areas? – How relevant are Price Rigidities (only for business cycles)? – If asymmetric business cycles: adjustment mechanisms? • Fiscal flows between areas (or some other kind of risk‐sharing)? • How mobile is labor between areas?

• How relevant are OCA criteria for EMU? Andrew Rose, Global Macroeconomics  EMU

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